Macroeconomic and financial market commentary

On “hopium” and the delusions of crowds.

“Religion is the sigh of the oppressed creature, the heart of a heartless world, and the soul of soulless conditions. It is the opium of the people.”

Karl Marx

In a world with scant, if any, religious feelings left, hope is the establishment’s spurious replacement. In the well known Marxist quote above, you just have to change the term “religion” and read “hope” instead. The wise but controversial adage is still valid today. The establishment and CB politburos have been using Hope & Opium to kick the ball forward -for a seemingly endless decade. So far so good, but it pays to remember that hope never was, and will never be, a viable investment strategy.

It’s bad for morale to discredit hope, and I am aware of the high probability of being ignored as the automatic defense mechanisms for “cognitive dissonance” immediately pop up. If you need the yield or the return (ROI), financially you just have to be “all in”. Most investors are additionally even selling some volatility to enhance their returns, regardless of being aware of assuming undue financial risks. It is all understandable. If I need the return, TINA is my criteria of choice (load up with equities, sell volatility). And if I were all in, I would hate to read my posts. Nevertheless, take a close look at the next chart. It shows the exuberant levels of risk in the system and gives me the shivers.

It could all well be the result of a new era. And, according to Heli-Ben debt doesn’t matter (LOL). Apparently, valuation doesn’t either (low rates are thought to provide a waiver that protects them from valuation excesses). But, at least, let’s look at financial valuations in relative terms (compared to physical assets) in the next chart. Sobering, ain’t it?

Finally, I can’t resist talking valuation in absolute terms, if only for a short overview. The Schiller CAPE confirms all our fears (see for yourselves online). So do charts on market cap related to gross value added, or price to revenues ratios -and all others that do not use “estimated future adjusted earnings” and current rates. That applies to most markets, Japan being the exception.

But complacency is soothing, and its appeal is difficult to resist when investors feel that they hold a CB put covering their back. No wonder everybody and their dog is short the VIX, and markets are rallying on little more than hopium. I have no words. I can do no better than Paul Brodsky at summarizing what’s going on.

“Rising markets, an unwillingness to acknowledge fat tails (unlikely knowns), and the inability to model Black Swans (unknown unknowns) have concentrated popular wealth into a narrowly distributed range of highly vulnerable assets and investment strategies. …

We cannot help but conclude that asset prices are generally rising due mostly to inertia, in spite of unreason, and that the most likely outcome will be something unexpected and disappointing. …

A socialized market framework with implicitly guaranteed perpetual positive returns for all must fail. … Helping to close unsustainable distortions is the only way capitalism can survive. Capitalism without failure is like Catholicism without hell.”

In such a complacent atmosphere, it follows that crushing hope is a bad strategy if you want to retain some credibility. Especially at this point in time, as markets have been notoriously risk-on of late. In ordinary people’s minds, that goes a long way to validate the thesis that all is well in the global economy. A nice, moderately expansionary business cycle in Japan and Europe, helps that perception as well. And all kinds of “soft” leading or coincident indicators are through the roof. Nevertheless, please remember that structurally nothing has changed, and hard data isn’t half as good, even in the midst of a benign business cycle in Europe and Japan. We still face the same challenges while endeavoring to develop the global economy, and dismantling the hopium apex is now a must for any economist on the Austrian side of the intellectual divide of the economics profession.

As Mises stated, there is no way out of a credit boom without a bust. You can delay the inevitable, but a bust will come at some point. It all depends on the amount of incremental liquidity provided to sustain the fantasy. This time is not different. In fact, if anything, this is a particularly delicate moment for society. Potential GDP growth is as low as it has ever been, labor skills increasingly inadequate, and the weight of entitlements will tax-crush, or deficit-kill any animal spirit sustained revival.

When talking timing, monetary aggregate growth is paramount. Incidentally, in the USA, the joint increment of both monetary aggregates (base money and total credit) does look as if it is slowing down. Nevertheless, don’t worry, globally, despite credit growth having stalled as well, CB’s are still adding liquidity to the tune of 200 billion USD per month (both charts below). Monetary expansion shouldn’t go on forever. When we get to the end of it, if we ever do (I am losing hope I will outlive this fantasy), a reduction in the incremental amounts of money will prove some or most of the hopium in the markets is entirely misplaced. Hope is better used in love and life. And opium and its derivatives, as a painkiller.

Once again, risk markets have done well. I have not. To be honest, it was a terrible month of March for me. What went wrong? A review of recent events can be done in short. To begin with, let me quote myself in the last post:

“Global financial and economic stability of an economy in such shape is NOT compatible with a strong dollar, inflation, or, when it comes, recession.”

We got none of the three, and that fostered animal spirits and helped the inertia mentioned by Paul Brodsky. All things equal, low rates, ample liquidity, and gross underestimation of fat tails (due to a perceived CB put), tilt risk markets upwards. A surge in equity prices and more stability in the credit and time spreads (that began a moderate flattening bias) were the result. Back trading is always easy!

1.- A weak dollar (helped of course by PBOC and G20 Central Bank intervention) was key to the outcome. As I explained in depth in my last post, the dollar is the cornerstone of global financial conditions. Dollar strength tightens, and dollar weakness eases. Deflating the dollar index alleviated most strains in global liquidity. Add some business cycle related optimism, and risk markets rallied big. I got it half right. I had underlined that a weak dollar would help risk, but foolishly assumed the FOMC would stick to their tightening course, and the dollar would not weaken much. Big mistake. The FOMC chickened out one more time. They ran out of courage a long time ago. I should have known better.

They did raise rates, nominally, but in Fed-speak they did a what is now known as a “dovish hike”. Absurd, I know. But that is how they managed the seemingly untenable position I mentioned when ending my last post: the need to hike for internal reasons, but keeping the dollar in check and global financial conditions easy. Fed-speak prose is now an ability superior to poetry. It is tough to talk up a dovish hike -and a challenge to sell the concept to most investors. Awesome stuff.

In the meantime, the dollar short is still there (see chart), but its effects are temporarily suppressed by a smart CB strategy and the time lag between the US and the European economic cycles. Look for more “dovish hikes” for as long as they want to keep the dollar weak. It is another issue altogether if investors will keep believing that that is the case for long: a dovish hike is a glaringly obvious oxymoron. It is like a warm iceberg or a light elephant. They are but human illusions.

Short term, we can see some dollar weakness coinciding with risk-off, as the reflationary trade dwindles at first in the US, and then elsewhere (Europe has a business cycle that lags that of the US). But in the medium to long term, be on the lookout for dollar strength, and assume a growing correlation of dollar strength with risk-off episodes, and vice-versa (CB’s and their POMO desks allowing). In the end, the dollar is the perfect proxy for global liquidity defined in broad terms. Be it base-money generated in the balance sheets of the Central Banks, or be it the more sophisticated version of credit-money, born because of the miraculous money making capacities of fractional reserve banking. We need more cheap dollars to keep this illusion operational. If we don’t get them, the economy and the bubble will stall -to say the least.

Ever since the end of the gold standard, and the completion of Volcker’s tenure at the FED, this has been a liquidity driven global economic model. No more money (base money or incremental credit) inevitably means, after years of addiction, no more growth. It would also mean the end of the “everything bubble”. And the ratio of the efficacy of money creation keeps deteriorating. It is now globally up to the tune of four to one. We only get one unit of real growth, for every four units of money or credit growth. If money doesn’t keep growing healthily, hopium is over for good. It might not happen, though -because most politburo members of the different CBs are well aware of that by now. Nevertheless, they might physically run out of options (see chart). It takes more and more fresh money to keep this going.

2.- Now that I mention the business cycle, I think that this second issue deserves more attention. First and foremost, I want to state again that I am positive that we will not succeed at reflating ourselves out of trouble in our current economic condition. Reflationary outbursts will all die away promptly unless we address the structural problems impeding stable growth.

I said in my last posts that I felt that this bounce in economic activity had been induced mainly by the Chinese extraordinary 2016 credit stimulus. European and Japanese QEs helped, but I felt that China was the most relevant factor. Well, I found a chart by Deutsche Bank that seems to validate this. If this is the case, I am all the more certain that it will be a short business cycle.

Anyway, structural constraints are still there. To have a long and intense upswing, we need active population growth (impossible nowadays), and healthy productivity increases (that need CAPEX to improve substantially). We lack both. The following charts are explicit enough.

We haven’t had a recession for ages, and for a good reason. CBs can’t afford it because a recession would probably end all this nonsense -it would undermine the belief that debt is sustainable and entitlement liabilities can be handled efficiently by an ever-growing global economy. Disturbingly, symptoms that all is not as well as it seems to be abound, together with some extraordinarily high soft indicators. It’s not easy to say when this cycle will cool down, but it can’t take long. Structural reality always exerts a strong gravitational pull.

3.- Third and last, as I said last month, nascent inflation could also spoil the show -if it keeps creeping up, tensioning real rates and the short end of the curve (the long end might remain protected if the cycle peters out as I expect). Crude has built a top, and I doubt it will continue to climb to the sixty dollar level. That should help mitigate inflationary pressures. But anyway, cost pressures ought to continue. Shelter, healthcare, and educational costs continue to mount (charts refer to the US, but this is a global phenomenon) and that will pressure labor costs sooner or later. Once labor costs are up, inflation or profit margins suffer. Both ways it would severely hurt risk price levels. Beware inflation, however moderate (yes, I know Keynesians see it the other way around).

On top of those ordinary risks: dollar, inflation and recession, we have the tail risks. China and Europe continue to merit a “fat tail” risk categorization. And China is an accident waiting to happen (see chart). Still strong short the Yuan. Only the timing worries me. But if the economic cycle is cooling as rapidly as I think, I think recessionary worries will take a front seat to slow or stop this irrational rally in risk. Inflationary cost pressures (Chart by Zerohedge) are also there, and effectively push the Fed towards more “dovish hikes”. We may not need fat tail risks to materialize.Stanley Fisher says two more hikes are a given. They will have to sell the “dovish hike” sophism twice again this year. Will they succeed?